This is huge. With today’s policy announcement, the Federal Reserve’s Open Market Committee has stopped screwing around and started doing real expectations-based monetary easing.

The new policy is a version of the plan from Charles Evans that I wrote about in March. They’ve said that interest rates will remain low until unemployment falls below 6.5 percent or the inflation rate exceeds 2.5 percent. That is a softer and weaker form of monetary easing than Evans originally proposed, but apparently a meager inflation target is the price you have to pay politically to get this done.

I think it’s huge in an intellectual sense, but not in a policy sense. The Fed had already committed to keep money easy well into the recovery. This makes that promise more explicit. Which is good. But it’s still a long way from level targeting. A Japanese-style zero percent NGDP growth path over the next 2 decades is fully consistent with this commitment.

At the other extreme some are claiming that the Fed has abandoned or weakened its 2% inflation target. Not in the slightest. The Fed has a dual mandate for low inflation (interpreted as 2%) and the highest possible sustainable employment (intepreted as roughly 5.6% unemployment.) Under that sort of targeting regime it’s appropriate to drive inflation below 2% when the economy is in a boom, and above 2% when unemployment is high. Their dual mandate policy framework calls for more than 2% inflation right now. If they were not targeting above 2% inflation they would lose credibility, indeed they would be breaking the law.

Of course the critics do have a point; it’s dangerous to set a vague composite target constructed of inflation and unemployment, where the Fed reaction function is unclear. Today they’ve made it a bit clearer, and they’ve made monetary policy a tad more stimulative. But they still have a long way to go.

A Japanese-style zero percent NGDP growth path over the next 2 decades is fully consistent with this commitment.

You mean gradual real growth that saw an almost doubled Real GDP Per Capita (PPP) from 1990 to 2010, or roughly 2.8% real growth per year?

That would be an improvement to what we have had for the last 4 plus years, wouldn’t it?

If Real GDP Per Capita (PPP) is the standard (which is of course not perfect, but flawed, but at least better than price indexes, GDP, and other stats that most economists, who say Japan has been stagnating for 20 years, have been using), then Japan is a case of relative success. Not amazing, but then not terrible either. Japan did better than France, Euro area, OECD total, Spain, Italy, Greece, New Zealand, S. Korea, Czech Republic, Portugal, Slovak Republic, Hungary, Poland, Mexico and Turkey…more highly inflationary economies than Japan, no?

Scott,
“A Japanese-style zero percent NGDP growth path over the next 2 decades is fully consistent with this commitment.”

I don’t see how. There is more to the Fed’s statement than just the commitment on rates. What about this part of the statement:

“If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until such improvement is achieved in a context of price stability.”

Zero percent NGDP growth in the US would result is a rising unemployment and falling inflation and this would result in additional Fed easing while continuing to link its policy actions to 6.5% unemployment and 2.5% inflation. Also, I think it’s pretty clear that the Fed won’t tolerate declines in TIPS spreads towards Japanese levels – significant declines in inflation expecations would be met with accelerated asset purchases.

Given this commitment could we have 4.5% NGDP growth with no level catch-up leading to a gradual decline in the unemployment rate and modestly below 2% inflation. Yes we could. But we won’t have 0% NGDP growth.

I am still very confused by the Fed clearly reiterating that it is explictly targetting downward pressure on long term interest rates. It wants a recession, wants deflation, and yet it doesn’t?

IMO, this Fed action is about bailing out the Treasury and flushing the banks with more money before the “fiscal cliff” Jan 1. They communicate it as reducing unemployment, but that’s purely subsidiary. If there was full employment, the Treasury and banks would still need bailing out.

The sooner you realize the Fed works for the banks and Treasury, the more understandable their actions will become.

“The sooner you realize the Fed works for the banks and Treasury, the more understandable their actions will become.”

That’s not apparent from their actions. They just linked their policy to the unemployment rate which contradicts your argument doesn’t it?

Assuming that you are stuck with a fiat currency and a central bank as the only issuer of currency. For some reason there is nothing you can do about it and the only choice you have is between recent FED policy and today’s announcement. Wouldn’t you choose the policy consistent with a lower level of unemployment (with stable low inflation)?

Assuming that you are stuck with a fiat currency and a central bank as the only issuer of currency. For some reason there is nothing you can do about it and the only choice you have is between recent FED policy and today’s announcement. Wouldn’t you choose the policy consistent with a lower level of unemployment (with stable low inflation)?

More inflation does not cause higher employment. Employment improves when the demand for labor and the price of labor are tending towards equilibrium. The Fed isn’t accomplishing that by buying t-bonds from the primary dealers.

This announcement is going to incur costs on those whose incomes do not rise as fast as their cost of living. You’re asking me if I am against this or the alternative? I am against BOTH, and stop presenting me with false alternatives.

The way the CPI is calculated now is a crime to the average American. CPI doesn’t measure standard of living anymore, it measures standard of constantly substituting crappier things for the stuff we would rather have. Not to mention the convoluted weighting-system they use which greatly diminishes the figures they publish. Even considering this, the CPI is *still* going up 2%/year….

I just can’t take anything the Fed releases seriously:

“To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee will continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.”

I mean if you accept disequilibrium in the labour market (i.e. unemployment) and that wages won’t rise with inflation (you called it cost of living) then it easy to figure out that higher prices result in lower unemployment.

Remember that what matters in the labour market is the real wage (W/P) so if P increases with a fixed or sticky W then the real wage decreases. We move along the downward slopping labour demand curve which implies lower unemployment. All this is based on what you wrote and contradicts your whole argument.

“This announcement is going to incur costs on those whose incomes do not rise as fast as their cost of living.”

This will increase employment because real wages will decrease.

Employment is not a causal function of real wages decreasing. See real wages since the 1970s.

In addition these people will have reduced “reservation wages” if you like and that would increase employment further (presumably because they would be willing to fill lower paid vacancies).

Inflation doesn’t enter the labor market, the unemployed labor market specifically, first. The Fed has been inflating since 2008, and prices have risen, and yet unemployment has persisted. That means if you’re empirically focused, more inflation doesn’t necessarily reduce unemployment just because there are unemployed people.

So your whole argument based on the above statement is wrong mainly because of the real wages change.

Except your responses are either wrong or don’t address what I am saying.

James in London:

MF Just for the record Ihave no interest in what you have to say. Please don’t waste your valuable time answering me. I only come here to question Scott and the Market Monetarists.

I have an interest in discussing economics with those who don’t share my worldview. I have interests beyond echo chambers.

If you don’t want to discuss economics with me, that’s fine, I don’t really do it for your benefit anyway.

Sarkis:

I mean if you accept disequilibrium in the labour market (i.e. unemployment) and that wages won’t rise with inflation (you called it cost of living) then it easy to figure out that higher prices result in lower unemployment.

How does accepting one imply the other? Demand for commodities (that which rises in price thus raising cost of living) is not demand for labor. Higher prices for goods does not mean unemployment goes down. See the 1970s stagflation, and the current stagflation.

Remember that what matters in the labour market is the real wage (W/P) so if P increases with a fixed or sticky W then the real wage decreases.

That is presuming that theory is true. I am disputing that theory.

We move along the downward slopping labour demand curve which implies lower unemployment. All this is based on what you wrote and contradicts your whole argument.

You can’t distinguish between moving along a demand curve, and being at new demand curves. Demand curves are mental tools, not empirically derived laws.

According to your thinking(and all inflationist schools including MM’s and Keynesians), Zimbabwe should have low unemployment rates considering their high inflation, correct? If there is that causal relationship, Zimbabwe shouldn’t have the 90%+ unemployment rate it has, should it?

What does it take for MMs and Keynesians, who are supposedly empiricists, to refute their beliefs about inflation?

What would falsify your quaint theories? And have you ever even questioned the premises your theories rest upon?

I know that demand curves are mental tools. That’s the reason we use them. Moving along the curve is in other words the “all else equal” argument. We mentally keep everything else fixed to see what is the effect of a change of one variable to another variable.

What do you mean I can’t distinguish between moving along and being at a new demand curve? I just did!

Employment is a function of real wages in the short run. The argument goes that by increasing employment in the short run you are positively affecting the long run equilibrium. Arguing against that would make more sense to me than referring to FED conspiracies.

Razer, you’re argument doesn’t work since Zimbabwe is an extreme case that does not relate directly to the case at hand. Zimbabwe is case of hyperinflation caused by political instability (civil war) and not by monetary policy (http://en.wikipedia.org/wiki/Hyperinflation_in_Zimbabwe).

Following that, I don’t think you can really compare unemployment in wartorn states to that in stable states, for reason too obvious to mention.

Giving the Zimbabwean unemployment rate as an example is just silly. We are not talking about dysfunctional economies here, we are talking about the US economy and US unemployment. I thought that the short run phillips curve was observed empirically.

“I am still very confused by the Fed clearly reiterating that it is explictly targetting downward pressure on long term interest rates. It wants a recession, wants deflation, and yet it doesn’t?”

I am baffeled by this as well.

“If 10 year treasury yields rose convincingly above 2% what would Fed do? Or rather, what would the market expect the Fed to do?”

Clearly a 4% 10 year rate would signal that the market expects the Fed to begin raising the short-term rate sometime fairly soon.

“Of course the critics do have a point; it’s dangerous to set a vague composite target constructed of inflation and unemployment, where the Fed reaction function is unclear.”

Really, how so? 1) the Fed is under no obligation to follow its own guidance, or can change its guidance let the market react and then change policies. 2) This is much less vague than the “considerable period” language that the Fed has been using.

“I am still very confused by the Fed clearly reiterating that it is explictly targetting downward pressure on long term interest rates.”

Bernanke is clearly suffering cognitive dissonance over interest rate targeting. On the one hand, they want lower long-term rates. On the other hand, Bernanke mentioned “getting off the zero bound sooner” in the Q&A today, as a justification for the QE_Inf policy.

so if we just get a few more seniors back to greeting part-time at walmart and a few more 25 year old gamers to sit in their parents basements all day and quit looking for work then the fed can stop QE?

Gregor. The US could have 0% NGDP growth and reach 6.5% unemployment via continuing declines in the participation rate. Although Gabe puts it more colourfully. Or maybe that is the future we would have had anyway. Customers like greeters and teenagers and twenty something’s love gaming. The games are great, cheap, entertainment, so I am told.

But the markets were basically flat on Wednesday. So how do you explain that? I’m guessing Scott would say that the markets are smarter than the commentators and the move was not looser (or tighter) than the markets expected. Ok, maybe that’s true, but my question to that is how do you move the idea that monetary policy drives markets beyond just a tautology? Don’t you need an independent measurement of what markets expect? Does there exist such a measurement?

Right… but they are committed to not doing less QE… So since the Fed has made these promises… How can the Fed counteract a fiscal stim if they keep their promise ?

Under these new Fed standards a fiscal stim would increase demand. And it would would not be counteracted by the Fed. So given stubborn stagnation and high unemployment, why not do a large fiscal stim ?

In other news… Brad Delong mentions Scott.

others of us went out to make the case for massive quantitative easing and changing the strategy space of the Federal Reserve in order to summon the Inflation-Expectations Imp and boost the trajectory of nominal demand. I am thinking of, among many, many others: Woodford, Sumner, Eggertsson, C. Romer, Hatzius and Stehn, Krugman, et cetera. Hatzius and Stehn (2012) marks perhaps the outer limits of what in our wildest dreams we would have sought in terms of expansionary Federal Reserve policy: committing to returning nominal GDP to its pre-2008 path and takng the Federal Reserve’s balance sheet up to $5 trillion along the way.

But more importantly De long thinks that the latest Fed move might just… ” End our Lost Decade”

“…If investors and markets are rational, holding cash and short-term Treasuries is no longer a way of insuring yourself against the nominal-stagnation lower tail. As of 12:30 PM yesterday, holding cash and zero-yielding short-term Treasuries is a risky bet that markets and investors will–irrationally–fail to recognize that the nominal-stagnation lower tail three years out is no longer there, or a risky bet that the Federal Reserve will reverse course and abandon its Evans Rule policies in the near future.

Will investors and markets be willing to bet on those risks? Or will they try to hedge by dumping short-term zero-yielding Treasuries and cash for equities backed by and for positions in currently-produced goods and services?

If they do the second, the Inflation Expectations Imp will shortly be summoned and our lost decade will be ended after only seven years.

If they do the first, then believers in the potency of monetary policy even at the zero lower bound will have a great deal of explaining to do, and sane policymakers will turn to carefully studying DeLong and Summers (2012), “Fiscal Policy in a Depressed Economy“.

Bill, The Fed can always change the amount of QE it does, it just changed the amount a few days ago.

This doesn’t mean that short term stimulus might not have some sort of very short run effect–but of course it’s a moot point because it isn’t coming. The only debate is over how much austerity.

DeLong dramtically overstates what happened yesterday. The Carney speech is far more significant. When the markets are telling you that your theory is wrong, you need to rethink your theory. The markets are telling DeLong that he misjudged what happened yesterday.

“I think it’s huge in an intellectual sense, but not in a policy sense. The Fed had already committed to keep money easy well into the recovery. This makes that promise more explicit. Which is good. But it’s still a long way from level targeting. A Japanese-style zero percent NGDP growth path over the next 2 decades is fully consistent with this commitment.”

See that Scott great minds think alike. Here’s Krugman:

“So, how big a deal was yesterday’s Fed announcement? Philosophically, it was pretty major; in terms of substantive policy implications, not so much.”

“Substantively, however, there isn’t that much going on here. Basically, Bernanke is promising that the Fed won’t do anything stupid — specifically, that it won’t pull an ECB, and raise rates even though the economy is still depressed and underlying inflation is still low. As it was, however, few people expected the Fed to pull an ECB in any case. That’s reflected in the market reaction: rates actually rose, and expected inflation, as measured by the spread between nominal and real rates, went up only slightly.”

“Sorry, but this move, while it speaks well of the Fed’s learning process, was not a game-changer.”

Bill, they are going take the foot off the gas as soon as inflation > 2.5 or unemployment < 6.5%. (They are still communicating in terms of keeping rates low, unfortunately – it would be a paradox if that led to real recovery.) Doesn't matter whether money or fiscal policy drives up spending, policy effects will be the same. But fiscal stimulus will be another punch in the gut to future generations. You know, the ones who are inheriting our polluted earth and everything.

“If they do the first, then believers in the potency of monetary policy even at the zero lower bound will have a great deal of explaining to do, and sane policymakers will turn to carefully studying DeLong and Summers (2012), “Fiscal Policy in a Depressed Economy”.”

How often do we have to remind them: we’re not monetarists, we’re Market Monetarists.

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Welcome to a new blog on the endlessly perplexing problem of monetary policy. You’ll quickly notice that I am not a natural blogger, yet I feel compelled by recent events to give it a shot. Read more...

Bio

My name is Scott Sumner and I have taught economics at Bentley University for the past 27 years. I earned a BA in economics at Wisconsin and a PhD at Chicago. My research has been in the field of monetary economics, particularly the role of the gold standard in the Great Depression. I had just begun research on the relationship between cultural values and neoliberal reforms, when I got pulled back into monetary economics by the current crisis.